What’s happening with my earnest money?

While experiencing a lingering case of writer’s block for this weekly column, I received an e-mail from a long-time reader with questions about his earnest money deposit. His problem was the return of his deposit after he decided to cancel the purchase contract after serious property defects were discovered during the inspection period. The seller would not sign the cancellation papers and return the money, claiming that he sold the property in “as is” condition while the buyer’s claimed that he was entitled to a full refund since the property defects were not disclosed.

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While experiencing a lingering case of writer’s block for this weekly column, I received an e-mail from a long-time reader with questions about his earnest money deposit. His problem was the return of his deposit after he decided to cancel the purchase contract after serious property defects were discovered during the inspection period. The seller would not sign the cancellation papers and return the money, claiming that he sold the property in “as is” condition while the buyer’s claimed that he was entitled to a full refund since the property defects were not disclosed.

As a Realtor first and a columnist second, I could not comment on the specifics of the situation or offer an opinion. According to the Realtor’s Code of Ethics, if you’re not a party to the transaction, you don’t get involved. Besides, there is always two sides of every story. So I suggested he go back to his agent or the broker/office manager with his problem. The situation, however, presented me an opportunity to discuss earnest money deposits and the rights of both buyer and seller to their disposition.

Most purchase contracts call for the buyer to deposit money into escrow (earnest money) once their offer is accepted. The money will be applied toward the buyer’s down payment and closings costs. The deposit is a show of good faith and a legal requirement in cementing the purchase contract. Typically, the deposit amount will be between 1 and 2 percent of the purchase price.

The majority of time this process works well. All parties usually enter a purchase transaction based upon the assumption that the deal is going to close. There are situations, however, when a contract is breached; one party defaults. A default not only jeopardizes the contract but raises the question as to what happens with the buyer’s deposit. Can the buyer simply demand a return of their deposit? How much of it, if any, can the seller claim? Who decides? Here are a few real life situations.

Case 1: The seller had accepted the buyer’s offer with a 30-day closing. The buyer was unable to close on time due to delays with financing. The seller and buyer could not come to an agreement on an extension and the seller demanded the buyer forfeit the $5,000 deposit and cancel the escrow. The buyer claimed that his failure to close was not his fault and demanded the earnest money deposit be returned to him. Who got the money? The escrow company!

Not forever, but until the parties or a court can make the determination the standard purchase agreement used by most agents provides that, in the event of a cancellation, escrow retains the money until both parties sign “mutual” cancelation instructions. Since both parties could not mutually agree to a satisfactory disbursement, escrow holds the funds.

Case 2: The accepted offer included the wording “Earnest money to be non-refundable.” During the buyer’s inspection period it was discovered that the property had serious issues and the buyer requested cancellation. The seller agreed to cancel the escrow but claimed he was entitled to the $25,000 non-refundable deposit as agreed to in the purchase contract. Who got the money?

In Freeman v. Rector, the court found that any provision in a contract “without any regard to actual damage suffered, would be an unenforceable penalty.” The buyer received most of his “non-refundable” deposit since the seller could not show monetary damages.

Case 3: The purchase price was $150,000 on a small rental which the buyer intended to occupy. After months of delays from the defaulting buyer, the seller decided to cancel the escrow and keep the buyer’s $7,500 deposit to offset his $8,000 in expenses keeping the rental vacant long after it was supposed to close. Both the buyer and seller, on the advice of their agents, signed the liquidated damages clause. How much money does each party keep?

The liquidated damages clause, found in the standard purchase agreement, limits the amount of forfeited earnest money the seller can retain up to 3 percent of the purchase price. Therefore, despite the seller’s $8,000 loss, he is only entitled to $4,500 and must return $3,000 to the buyer. Liquidated damages generally favors the buyer since it limits the buyer’s liability. The advantage for a seller is that they need not prove damages in court because the amount of damages has already been agreed to in advance.

Case 4: A dispute between the buyer and seller arises over who is entitled to the earnest money deposit. When the contract was signed, both the buyer and seller agreed to the mediation and arbitration clauses of the contract providing an alternate dispute resolution to litigation. The buyer files an appropriate request for mediation/arbitration. The seller, a practicing attorney, refuses to abide by his previous agreement to mediate/arbitrate. The buyer’s remaining recourse would be to file a lawsuit against the attorney/seller to enforce the arbitration clause. How much of the buyer’s deposit is eventually recovered? None. It is often too expensive to litigate.

There are a number of safe-guards in the standard purchase contract that protects a buyer’s earnest money deposit. However, each contract is unique and occasionally stuff happens that can put the buyer’s deposit at risk. Buyers should have a good understanding of their contractual responsibilities before writing that check.